UK interest rates: what goes down must come up?

On 2 November 2017, the Bank of England’s Monetary Policy Committee (MPC) will meet to decide the direction of the UK bank rate. The UK bank rate is an important economic measure, as it’s the rate at which the Bank of England charges financial institutions for loans over one day, and the rate at which wider interest rates — such as those for savings and mortgages — are set.

Ten years ago, in October 2007, the rate stood at 5.75%. Today, it’s at a historical low of 0.25%, having been slashed significantly following the global financial crisis (to 0.5% by March 2009), with a further 0.25% cut following the EU referendum in 2016.

These historical lows are unprecedented, but you’d also need to go back to the 1940s to find a time where the bank rate has stayed so relatively static for such a sustained period.

Is the rate about to go up?

At the MPC’s September meeting, the committee voted 7-2 in favour of maintaining the current level of interest rates. Since then, Governor Carney has suggested on numerous occasions that the committee may be ready to raise interest rates, and this month’s inflation and wages data may have strengthened the case to do so.

However, some market commentators believe that Governor Carney’s comments are intended only to prop up the price of the pound and reduce the inflation pressures of import prices — rather than demonstrating the committee’s immediate intention to raise interest rates.

The case for a rise in interest rates

Despite the continued uncertainty surrounding Brexit, the UK economy has remained relatively robust through 2017 with GDP growth surprisingly resilient, aided by a recovery in global trade and a weaker pound.

The severe depreciation in the pound following the EU referendum has led to rising import prices, which in turn have fed through to higher prices for consumer goods and services. Inflation data for September saw inflation rise to 3% — its highest since April 2012 — and a full 1% above the Bank of England’s target. While the Bank believes inflation may be close to peaking, it does acknowledge that inflation is likely to overshoot its 2% target for the next three years.

Meanwhile, employment trends continue to show strength. The UK unemployment rate is at a 42-year low, while the employment rate is at a record high and employment growth shows continued strength. However, wage growth continues to be subdued with the latest data showing that wage growth significantly lags behind inflation at just 2.2%, meaning real incomes (and affordability) are decreasing.

This has presented the Bank of England with a dilemma. The economy doesn’t appear to be at risk, inflation is higher than its target and the current historically low level of interest rates can’t be sustained forever, especially as it reduces the levers the Bank has to support the economy should there be another crisis.

Keeping interest rates so low at a time when operating capacity is so strong risks promoting cheap borrowing. But, wage growth remains subdued, and the Bank needs to balance the need to control inflation with the need to support jobs and activity.

What does this mean for me?

For UK consumers, the recent outlook has been fairly bleak, despite a broadly robust outlook for the UK economy.

Inflation at a five and a half year high means the value of cash savings is being significantly eroded, and with wage growth lagging inflation consumers continue to be poorer in real terms. For borrowers, any increase in interest rates will further heighten expenses.

While for savers an increase in the base rate is better news, the expected 0.25% increase is unlikely to make a significant difference to savings rates and provides little defence against the current level of inflation. And with the Bank of England clearly stating that any increases in interest rates will be gradual, it’s unlikely that savings rates will be back above inflation any time soon.

How Nutmeg is preparing for an interest rate rise

In our fully managed portfolios, we’ve recently held less Government bonds than we would typically expect to hold over the long-term. This is due to the negative impact interest rate increases have on these assets and our expectation that the end of quantitative easing programs will reduce demand for these assets.

We’ve also reduced the interest rate sensitivity of our portfolios (known as duration), to further protect portfolios from rising interest rates both in the UK and the United States.

Instead, we continue to favour equities over bonds, particularly those markets that are best placed to benefit from a rise in global trade, such as Japan and emerging markets, and those demonstrating exceptional economic strength, such as the United States.

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past or future performance indicators are not a reliable indicator of future performance.

Sources

1. Bloomberg, 19th October 2017.